I'm here to discuss risk taking. R-squared is for Ranting and Raving, R&R, as well as some more technical topics

Monday, June 14, 2010

Private Equity Versus School Teachers

Here's my hypothesis: All parents believe their kids are above average students, therefore grade school teachers pay falls short of private equity managers.

Suppose you manage your investments with some help. You'll only make a small number of these investments in your lifetime, and you can't really undo your decisions. You use help, but you know for certain you are a better than average investor. You hire people to help you on a series of short term contracts. You definitely know you need the assistance, but the investments you make have a very long time horizon, the return on investment won't be known for many years, and really, you don't give them much credit because you know you're a good investor.

Now, suppose you don't think you're a better than average investor. In fact, you find the whole process intimidating, you don't have the time or the skills to make good investments. This lack of confidence drives you to hire long term advisors, give them broad discretion, and you hang on every word they utter. Everything else is the same as before.

How do you pay your advisers in these different situations? In the first case, you probably pay them very little. In the second case, you pay them very well. Only your confidence changed. The first scenario describes investing in childhood education. The second describes many illiquid investments, particularly private equity.

There's an endless supply of data on people's overconfidence in almost everything. Who thinks they're a below average driver? Probably about the same fraction of parents who say their kids have below average intelligence. (I would love to see the shock in a conference between a parent and a grade school principal when the parent says "my child's teacher is so intelligent, I don't think my idiot kid can learn from him.")

Similarly, the evidence that people chase performance in the investment world may be as common as rooms filled with above average drivers. Yet people still pay huge sums for little value added.

I suspect many parents and many investors would be better off if they realized that (1) their children may actually be below average students and, (2) other peoples' children may not grow up to be above average investors.

3 comments:

I think investors who pay private equity managers to invest for them actually believe they are better investors than average, which is why they can get to the right private equity guy and know how much money to give him.

I think the same is true of grade school teachers who make good money (Horace Mann, anyone?) The parents who pay extra think their kids are super bright and therefore need superbright teachers to teach them.

Superbright is coming up in my spellchecker. I am not sure what's right. And, I think it's why my parents forked over enough to send me to a great public grade, but not a good private school: above average writer, but my spelling really brings me down :)

With regard to Horace Mann, I think you're supporting my argument. Much Horace Mann tuition (high, but not really that high by NYC standards) goes to non-teacher expense and redistribution of wealth, (financial aid.) Expensive schools does not equal high paid teachers.

Financial aid reflects the school's (and possibly parents, but call me cynical and heartless, but the parents who can afford often don't truly care about diversity, they probably care because they are supposed to care in order to get their kid into the school...) Which brings us back to you're paying a fortune and not getting value.

A better argument might be that parents are essentially indifferent as to quality of education, but they seek to pay up to project perceived or actual "values" from a school. Moreover, this could be a good strategy for a school since differentiation based on educational outcomes must be extremely difficult.

Penelope requested that I post my private response to her, so here it is, redacted only slightly...to remove my kid's school non-essential detail...

So, Horace Mann says in their tuition FAQ that 85% of tuition goes to teachers' salary and benefits. My first reaction was that sounded huge and extraordinary, and must mean teachers are very well paid.

However, I think it's completely (probably intentionally) misleading. It's a lot like Robin Hood Foundation saying 100% of contributions go to support programming, and there's zero overhead. Robin Hood does this because the Robin Hood board of trustees pays all the overhead. It's an accounting and marketing gimmick.

I checked with the CFO of [my kid's private school in NJ]. I'm not saying they're efficient or a good standard by any stretch. However, she said salaries and benefits are about 80% of budget. 60% for teachers. 20% admin and support. That's total budget, not tuition.

We know from HM that their annual campaign raises about $4 million.

1781 students, call it average tuition of $30k. $53 million. Subtract $7.5 of financial aid because that's an accounting fiction in revenue and expense for a school. So, we have $45 million real tuition revenue. of that, 85% is teacher salaries and benefits, or $38 million.

Then, adjust for annual fund income of $4 million, and endowment income of another $2 million conservatively (~$70 million endowment.)

So, now we're at a ballpark real cashflow of $45 + $4 + $2 = $51, and teachers salary and benefits of $38, or 75%.

About Me

Since completing my PhD in economics at the University of Chicago, I have worked at financial firms ranging from the insanely large (JP Morgan) to the ridiculously small (my current venture has one employee!) with stops in between investing for McKinsey & Company, and Silver Creek Capital Management. I have served on company boards, both public and private.
You can reach me at marc@riskrsquared.com